29 September 2007

Our analysis after the company's second quarter yielded an Overall Gauge score of a weak 23 out of 100 points. While there were some encouraging Growth and Profitability signs, the double-weighted Value gauge dragged down the Overall score. We fretted about the Finished Goods/Inventory ratio increasing to 40.6 percent. We determined that neither the value of this ratio, nor the magnitude of the increase from the previous quarter, can be explained solely by seasonal factors, if history is a valid guide.

More optimistically, BUD announced last July that "it was on track for earnings to accelerate in the second half of the year, and maintained that 2007 earnings growth would be higher than its long-term target of 7 percent to 10 percent." A similar statement was made in early September, with the added tidbit that sales are accelerating.

Year-over-year Revenue growth has recently been a tepid 4 percent. Given the company's rosy statements, we've decided to look for third quarter revenue of $4.63 billion. This figure is 8 percent greater than the Revenue in the comparable year-earlier quarter, and it translates into year-over-year Revenue growth of 5 percent.

We're assuming the Gross Margin will be about 37 percent of Revenue because of the company's guidance. Thus, the Cost of Goods Sold (CGS) should be about 63 percent of $4.63 billion, or $2.92 billion.

Given the optimistic guidance about Equity Income, we expect this value to be $188 million. This is 20 percent above the value in 2006's third quarter. If we assume a Net Interest expense of $110 million, pre-tax income will be $1004 million. (Strictly speaking, the equity income shouldn't be included in this figure since it is net-of-tax.)

With normal Income Tax Rates applying, we can assume $311 million in income tax. This would leave us with Net Income of $693 million ($0.91 per share).

22 September 2007

A look at a stock chart indicates that the late-Summer market downturn barely affected PepsiCo, and the shares are now trading near a 52-week high. The weak dollar increases the attractiveness of companies with significant overseas operations, which is certainly the case for PepsiCo. Also, in an uncertain economy, investors are drawn to blue-chip cash generators and industries satisfying the steady, predictable demand for food and beverages. But the PepsiCo 's appeal is not a simply a recent phenomenon: PEP shares have been advancing steadily for almost three years, from below $50 to over $70. The company also pays a dividend of about 2 percent.

Our assessment of PepsiCo after the second quarter was generally positive. Revenue was higher than we forecast, and many expenses were lower. As a result, Operating Income was 14 percent above the predicted value, and Net Income exceeded our forecast by 18 percent.

The Overall gauge score in June of 42 seems weak, but that is misleading. The gauge for PepsiCo is now at the top of its historic range. For whatever reason, the score for PepsiCo never gets very high, but the trend (i.e., increasing scores, as is currently the case) is more important than the absolute level. We've observed that future increases in PepsiCo's stock price correlate fairly well with increases in the Overall score. In other words, rising scores have presaged price increases. With 28 quarters of data, the degree of correlation coefficient between these two parameter is 63 percent.

As usual, prior to the release of another quarter's earnings, we find ourselves wondering if the good times at PepsiCo will continue. By most accounts, they are one of the better managed companies in the country. What is reasonable to expect?

In February, PepsiCo provided guidance for 2007 indicating "the Company expects mid-single-digit volume and net revenue growth, with revenue growth outpacing volume growth." With this in mind, we're looking for third-quarter revenues of $9.74 billion. This figure would equate to 8 percent year-over-year revenue growth and almost a 9 percent increase over the September 2006 quarter.

The gross margin for PepsiCo always seems to be about 55 percent of revenue, so we're comfortable estimating the Cost of Goods Sold at 0.45 * $9.74 billion = $4.38 billion. Similarly, SG&A expenses are usually right around 36 percent of revenue, so our assumption for these costs in the third quarter is 0.36 * $9.74 billion = $3.51 billion. We'll also assume a flat $40 million charge for amortization of intangible assets.

Bottler equity income is both significant and erratic. However, income in the September quarter tends to be strong. Since bottler equity income was $173 million in the June quarter, we think it is reasonable to expect an income of $220 million in the third quarter.

A $20 million charge for net interest expenses seems reasonable given recent history.

The income tax rate presents another complication. The company indicated that tax rate volatility will continue, but they are assuming that the average for year will be 27.3 percent. We've used this full-year estimate for the third quarter.

Rolling up these estimates, we're looking for net income of $1.46 billion ($0.89) for the quarter. As you can see, we're not looking for much more than a flat quarter. However, we have to note that our net income prediction is much less than the estimates of professional analysts. We tend to be conservative with our numbers. However, the magnitude of the difference is surprising because PepsiCo's operating expenses are fairly constant as a percentage of revenue, and we have some guidance from the company concerning the revenue. Amortization expenses and bottler equity income are the values of which we are most unsure. We used historic averages for these figures, but, perhaps, the professional analysts have better information at their disposal. We've also been tripped up in the past by the company restating the year-earlier results, which changes the baseline for out growth predictions.

We noted some specific concerns about Tidewater's June quarter when we last analyzed the company. Our Overall Gauge for Tidewater dropped to 45 points from a more robust 61 points after the March quarter. It's not that Tidewater had a bad period -- just the opposite, really -- but the pace of revenue growth slowed and expenses were higher than expected. In addition, the then-rising stock price (the decline began in the latter half of July) weighed heavily on our valuation metrics.

Some of the higher expenses in the June quarter might have been the result of non-recurring costs that don't have long-term significance. We'll be able to assess this when the September results are published.

Revenue started to surge at Tidewater in late 2004, after a couple years of flat (or declining) performance. The growth peak was in June 2006, when quarterly revenues were 40 percent greater than the year-earlier period. By comparison, revenues in the June 2007 quarter were just 13 percent greater than in June 2006.

We will view similar revenue growth, 13 percent, in the September quarter as good. Our specific prediction for the September 2007 quarter is $311 million, compared to $274 million in the earlier period.

Tidewater's gross margin increased steadily, from about 35 percent to almost 55 percent of revenue, until falling back to 51 percent in the June quarter. The modernization of the Tidewater fleet and their growing international presence provides good reasons to be optimistic about the gross margin. We're going to look for a rebound to 53 percent for the September quarter. Given our revenue estimate, we're looking for a Cost of Goods Sold of 0.47* $311 million = $146 million.

Depreciation has been between 10 and 11 percent of revenue in recent quarters and declining. We'll assume the lower value and forecast a Depreciation expense of 0.1 * $311 million = $31 million for September. Similarly, if trends continue, SG&A expense should be about 9 percent of revenue. This equates to $28 million.

As a result, operating income of $106 million seems attainable. If we guess an additional $10 million in income from asset sales and interest, and a 21 percent income tax rate, our estimate for net income become $91 million. (Note that gains on asset sales were abnormally high in September 2006, which makes comparisons unfavorable.)

The beginning of this calendar year -- it was the third quarter of fiscal 2007 for Microsoft -- saw the launch the consumer version of its Vista operating system. This event resulted in quarterly revenues surging 32 percent over the value attained in the period ending March 2006. The revenue increase was not as dramatic in June quarter: 13 percent compared to the year-earlier value.

When we evaluated Microsoft after the results from June became available, our Overall Gauge read 46 out of 100 possible points. This score was down from an encouraging 51 points after March. The small drop-off reflected the fact that there was nothing particularly surprising about the March quarter and that Microsoft shares had already moved up, albeit modestly.

In October, Microsoft will announce their results for the quarter ending on 30 September 2007. When the results from June were publicized, Microsoft provided some guidance about what they expect in the current quarter and the fiscal year that will end in June 2008.

The company forecast that revenue in the September quarter would range between $12.4 and $12.6 billion. This would seem to be a fairly conservative estimate, as it is less than the June quarter, much less than the March quarter, and about the same as the December 2006 quarter. However, September quarters are historically weak, and the mid-point of the forecast is about 15 percent greater than the revenue of the September 2006 quarter.

Microsoft's Gross Margin is typically over 80 percent (!). If we set the target for the current quarter at 83 percent, the Cost of Goods Sold will be 0.17 * $12.5 billion, or $2.125 billion. R&D expenses have recently been 14 to 15 percent of revenue. We're going to assume the lower number because the trend has been down. Therefore, we expect R&D expenses of around $1.75 billion. SG&A expenses are typically around 30 percent of revenue, which would equate to 0.30 * $12.5 billion = $3.75 billion, for September quarter. Note that we're assuming that any special charges due to faulty Xboxs were fully expensed in the June 2007 quarter.

The estimates above would translate into an Operating Income of about $4.875 billion. The is a little below the $5.0 to $5.2 billion range forecast by Microsoft, but we're not aware of any reason to expect below-normal costs. We would not be surprised at all to see Revenue come in higher than the company forecast, which would push up operating income

The reduction in Microsoft's cash hoard due to share repurchases undoubtedly cut into interest income. We'll assume net interest income was $350 million.

We'll also assume an income tax rate of 30 percent, which leads to a Net income value of $3.658 billion ($0.38/share). Net income was $3.478 billion in the year-earlier quarter.

03 September 2007

When we evaluated Intel after the second quarter, we found a tug-of-war between the positive forces of Revenue Growth and the negative forces of a lower Gross Margin. The deciding factor turned out to be a temporarily lower tax rate, which enabled profits to beat estimates. Our Four Gauges were unimpressed by tax factors and the effect the surging stock price was having on valuation. As a result, the Overall Gauge score was a mere 20 points.

Intel shares, which were up 24 percent in the second quarter, moved up another 8.5 percent in the July and August despite the market turmoil. Market conditions might even have contributed to the price rise, as well-capitalized high-tech companies were seen as being insulated from the stormy financial and housing industries. There's also little doubt that Intel's stock has been helped by favorable reviews given to Intel's newest products and predictions that Intel will regain market share from steadfast competitor Advanced Micro Devices (AMD).

When looking ahead, our normal approach is to extrapolate from the past and to make some adjustments based on credible current conditions and forecasts. In their second quarter report, Intel was quite specific, with appropriate caveats, about their expectations for the third quarter. Since management knows their business infinitely better than we do, we can rely less on our own extrapolations.

Revenue in the June 2007 quarter broke a succession of quarters in which sales were less than in the year-earlier quarter, although revenue was still down when measured on a year-over-year basis. In July, Intel estimated that revenue in the September quarter would be between $9.0 and $9.6 billion. The midpoint of this range, $9.3 billion, would equate to a 6.4-percent gain over the year-earlier quarter. Year-over-year revenue growth would be a modest 1.8 percent, but at least it would be positive (a welcome change). Professional analysts have also centered their aim just a tad above the midpoint value of the range announced by the company; their revenue predictions average $9.36 billion.

In the face of intense competition, Intel's gross margin has dropped from percentages in the high 50's to the high 40's. Intel signaled that the gross margin in the third quarter would be 52 percent, plus or minus a couple of percentage points. A five percent increase in gross margin from the second quarter (47 percent) to the third quarter seems too optimistic to us. We would be happy to see the figure get back above 50 percent. However, we're going to give the company the benefit of the doubt. Given the revenue estimate above, Intel is telling us to expect a cost of goods sold of 0.48 * 9.3 = $4.5 billion.

After a year or so where R&D and SG&A expenses had each inched up to about 17 percent of revenue, Intel has had some recent success in bringing these costs back down toward historic levels. We're assuming these two expenses will each be about 15 percent of revenue, or $1.4 billion for each expense. Left to our own devices, we would have made provisions for an additional $90 million of operating charges, which is the average value for the last 10 quarters. However, Intel told us to expect $150 million of these expenses, so that's what we will do.

The aforementioned assumptions lead to an estimated Operating Income of $1.9 billion, a hefty 38 percent gain over the year-earlier figure.

If we had used historic averages for gains on investment, net interest, and other income, we would have estimated $230 million for non-operating income. However, the company told us to expect $320 million. This would result in a predicted level of Income before Taxes of $2.2 billion.

Effective income tax rates shouldn't change dramatically from quarter to quarter, but the resolution of a dispute with the IRS led to wide swings as Intel was allowed to reverse some previously accrued taxes. This caused the first and second quarter tax rates to be abnormally low. For the tax rate in the third quarter, we'll use Intel's estimate of a more typical 29 percent.

With all these assumptions, Net income in the third quarter will be $1.6 billion ($0.27/share), up from $1.3 billion in the year-earlier quarter. Analysts are assuming $0.28.

A reminder: the company's estimates for gross margin, special operating changes, and non-operating income are all higher than we would have assumed based on historical data.

01 September 2007

In the last week, we worked on a handful of analyses, including attempts to calculate gauge scores for ADP and Home Depot. However, in each case corporate M&A activity kept us from ascertaining with confidence the consistent historic financial record required by our methodology.

Companies provide restated results after significant deals, but we often find ourselves with a heap of new data for some quarters and old data for others. It's truly baffling to have a restated income statement, old balance sheet, and ambiguous cash flow data for a particular quarter.

Sometimes this sorts itself out after a few quarters. We would rather defer an analysis and wait patiently for a financial baseline to emerge than make apples-to-oranges comparisons.

We would like to see more companies keep a 3-to-5 year consistent set of financial data by quarters on their web sites. We commend those companies that make a good faith effort to keep investors supplied with relevant data, and we're hopeful the others will do more.

With that, and given that it is now September, we're going close the book on the second quarter and start looking ahead to the results that will become available in October and November.

Disclosure

This blog describes and gives examples of a particular quantitative methodology, relying on published financial statements, to analyze businesses. The methodology does not evaluate every aspect of a company's finances or operations. Other analytical techniques may be better suited to some evaluations, depending on the type of business or the goals of the analysis. The material in the blog is not investment advice, nor does it constitute an offer or solicitation to buy or sell any security. The author might have, might once have had, or might be considering a position in the companies mentioned. Specific positions will not be disclosed. While good-faith efforts are made to use reliable information sources and to provide accurate analytical results, accuracy is not guaranteed. All results are subject to change without notification. Application of the analytical methodology described in this blog requires that various assumptions be made. The assumptions are generally not disclosed and are subject to error, invalidating some or all of the analysis results. In looking for trends, recent financial data is compared to historical financial data; however, underlying differences in the assumptions or presentation of the data might degrade or invalidate these comparisons and could produce erroneous or misleading results. Readers should independently validate any information in this blog that causes them to consider making or not making a financial transaction.